Data could test the Fed's patience

Can rates stay low with numbers suggesting growth?

WASHINGTON (CBS.MW) -- These are the times that try the backbone of a central banker.

Can the Federal Reserve maintain its very easy monetary policy in the face of data that show the U.S. economy is finally on the mend? Will the Federal Open Market Committee hold the line against rate hikes, fighting every instinct that's ever been bred into central bankers? Or will bond market bears force the Fed back into its old routine of seeing growth as the enemy of stable prices?

Fed officials have made it clear that they intend to keep interest rates right where they are (more or less) "for a considerable period." Several Fed officials, including Gov. Ben Bernanke, have suggested that the economy needs several quarters of above-average growth to wring the excess capacity out of the labor market.

These central bankers still see the risk of deflation, however small, as a greater threat (in terms of consequences) to a healthy economy than the possibility that fast economic growth will fan the flames of inflation before the Fed can react.

The coming week will test the Fed's resolve two weeks ahead of the next meeting of the FOMC. A busy calendar of releases could show gathering strength throughout the economy, from retail to housing to manufacturing.

And it could also show that, despite what the Fed says, consumer prices are still rising at a steady clip.

Bond yields are poised to soar once the growth story is confirmed, in part as a natural consequence of the business cycle as riskier investments become more favored. Traders are also pushing up longer-term yields to guard against either inflation or a Fed tightening.

"There is a limit to how steep the yield curve can get -- if the Fed just says no -- again and again!" said Paul McCauley, managing director of Pimco.

The bond market bears are also forgetting one small detail when they anticipate much higher rates next year.

The data

The week brings four of the most important monthly indicators, starting with the September retail sales report on Wednesday. Then we'll see the September consumer price index and September industrial production on Thursday, followed by September housing starts on Friday.

The Fed itself will weigh in on Wednesday with the Beige Book's summary of economic conditions, as seen through the eyes of the Fed's army of economists.

The retail sales report will be crucial. Consumers took advantage of a tax rebate check and mountains of unleashed home equity to go on a shopping spree in August. But September looks to be weaker.

Economists are forecasting a 0.1 percent month-over-month gain in retail sales for September, down from August's 0.6 percent gain. Much of the slowdown can be traced to the auto sector, where sales plunged from a rate of 19 million annual units (the second most ever) to about 16.7 million.

Excluding auto sales, economists are expecting retail sales to rise about 0.5 percent, not far from the 0.7 percent gain in August.

Retail chain store sales were strong in September, with same-store rising 5.9 percent year-over-year. Consumers paused earlier in the month, but came back to the malls in droves the final two weeks of the month.

The sustainability of consumer spending is a big question mark. With the effects of the tax cut and the refinancing boom fading, consumers will have to rely more and more on their income from wages and salaries to finance their spending.

But wage growth is slowing along with the weak job market.

The state of the consumers' psyche will be on display on Friday when the University of Michigan leaks the results of its consumer sentiment survey. Economists expect sentiment to be broadly unchanged at about 87.7, the same as in September.

Factories

The manufacturing sector appears to be gaining strength, even if there's no hiring at the factory gates yet. Economists expect a strong 0.4 percent gain in industrial production in September after a tame 0.1 percent gain in August.

We'll also see the first inklings of how the sector is doing in October with the Empire State index on Wednesday and the Philadelphia Fed index on Thursday. The two regional surveys have been trending higher.

Economists are looking for a pullback in the New York Fed's Empire State index to about 15.8 from 18.4 in September. The Philly Fed index should strengthen to 15.9 from 14.6, the consensus says. In both surveys, readings over zero indicate that a majority of firms are finding better business conditions.

Even though mortgage rates have risen from July's historic lows, home construction hasn't suffered. Economists expect starts of new houses to be little changed from August's 1.82 million annual rate.

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